2001 Review: Stocks Stuck in the Back Seat

Market watchers have spent most of the past year trying to find the right historical context for the dramatic declines the major averages suffered. As it turns out, stocks are probably the last thing anyone will remember about 2001.

That's because of the succession of almost surreal events that attended the year's final quarter, including the Sept. 11 terrorist attacks, the war in Afghanistan and the onset of a full-blown recession. While the decline in the equity markets has been substantial, the pain has been supplanted by a more immediate concern for job security, as well as interest in the measures being pursued by the Fed and federal government to bring the economy back.

But stocks have also become less of a story because, quietly and reassuringly, the averages have shown remarkable resilience amid the upheaval.

Sure, the Dow Jones Industrial Average has lost 6% in 2001, the Nasdaq Composite has tumbled 23%, and the S&P 500 is off 11%. But notably, all three have withstood the trauma of Sept. 11 and risen hardily above their worst postattack levels.

With the Dow up 20% in November from a three-year low in late September, market pundits hailed the birth of a new bull. Whether that will last is a story still to be written.

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Meanwhile, more stocks than you probably think have done better this year. The advance-decline line on the New York Stock Exchange has been climbing since last October, meaning more stocks have been rising than falling.

Just Tack on an N The Dow through a down year

Source: BigCharts.com

"The thing that's struck me most about the past year," said Richard Dickson, a technical analyst at Hilliard Lyons, "is that we had a relatively mild bear market outside of technology stocks." Even the techs -- down 60% from their peak of 5048 on the Nasdaq in March 2000 -- have shown signs of life. In fact, they've led the rally since late September, with the Nasdaq up 40% from its postattack low.

When it comes to the relative performances of market indices, the success story of the year has been smaller-cap stocks. The Value Line Arithmetic Index, an equally weighted average of 1,700 companies, shows it best. It's up about 6%, while indices weighted in large-cap stocks are down. And the small-cap Russell 2000 is up about 5% for the year.

A rotation into mid- and small-cap stocks gained momentum with the burst of the stock market bubble in 2000, driven by valuations. At the time, many large-cap stocks were expensive, compared with mid- and small-cap stocks.

Late Bounce The Nasdaq in 2001

Source: BigCharts.com

"The trend was so pervasive that six months ago the valuations of mid-cap stocks caught up with those of large-cap stocks," said John Bollinger, president of Bollinger Capital Management. But with the recent surge in large-cap stocks, the valuations of smaller ones have begun to look attractive again. Currently, the S&P 500 trades at a price-to-earnings ratio of 24, while the S&P SmallCap 600 has a price-to-earnings ratio of 22.

"It is common for smaller-cap stocks to be priced using a higher required risk premium than larger-cap securities," said Abby Joseph Cohen, chief equity market strategist at Goldman Sachs, in a research note last week. "But based on consensus earnings expectations, it appears that the current gap in risk premia is wider than normal. This suggests that the valuation for smaller-cap stocks is more appealing than that of larger-cap stocks."

Heroes

The strength of the little guys is thought to be sustainable. "After a strong relative performance in 2001," said Cohen, "2002 should bring a replay of many of the flows and business-cycle factors that were catalysts in 2001."

Coming out of a recession, small-cap stocks tend to do better than their large-cap brethren. In the year following each of the 10 post-World War II recessions, small-cap stocks outperformed large-caps by 14.1% on average, according to Ned Davis Research, a market statistical service.

Small-cap value mutual funds are up 13.3% this year, while large-cap value funds are down 7.2%, according to fund tracker Morningstar. Small-cap growth funds are off 11.2%, while large-cap growth funds are behind 23.8%.

Big in Heart Russell 2000 this year

Source: BigCharts.com

"The pattern is clear," said John Waterman, managing director of investments at Rittenhouse Financial. "Small has been better than large, and value better than growth," though the reverse has been true in the recent rally.

All the Madmen

Most experts think the economy is going to show signs of stabilization in early 2002. But after a year in which so many market analysts were badly wrong, they're being much more cautious with their forecasts.

"We thought the Fed was going to engineer a soft landing in the economy," said Charlie Reinhard, a senior equity market strategist at Lehman Brothers. "It wasn't until February that we began forecasting a profits recession." At the end of last year, Reinhard said the S&P 500 would be trading at 1,675. For next year, he's thinking 1,350.

Many analysts think the Nasdaq has outrun itself since Sept. 21. "I don't think the Nasdaq's gains are sustainable," said Dickson of Hilliard Lyons. "We should see some profit-taking in those stocks."

More Poor Than Standard S&P 500 in 2001

Source: BigCharts.com

Some experts are equally skeptical about the broader market. "We expect another down year," said Thomas Van Leuven, market strategist at J.P. Morgan, "based on the belief that we're starting out with rich valuations." Last year, he predicted the S&P would top out at 1,400. But in the coming year, he expects it will fall to 940.

"What we'd like to have more clarity on is the earnings recovery," said Van Leuven. "We could still see profit margins contracting for a while because labor costs are still significant."

To Earth

At the end of last year, research analysts forecast S&P 500 earnings growth of 9.2%, according to Thomson Financial/First Call. Instead, earnings growth contracted almost 17%. Looking ahead, analysts are calling for earnings growth of 15.2%, a number that could easily fall to the single digits.

From 1979 through 2001, the major indices netted approximately 11% to 12% a year. But in the late 1990s, they rallied way beyond the norm, with the S&P 500 tacking on 20% or more per year from 1995 to 1999. In the year ahead, some say average returns could be possible, absent events like terrorist activity.

There is one thing going for the market in 2002: "It's very rare that you have three down years in a row," said Sam Burns, an analyst at Ned Davis Research. "The last time that happened on the Dow and S&P was 1939-41."